From our practice as a tax law firm with a focus on corporate taxation, we know that the tax office often expresses suspicion of misuse of design in company audits. However, our experience also shows that only in a few cases a misuse of design can actually be proven by way of the objection procedure and possibly also the action before the tax court or even the Bundesfinanzhof. Nevertheless, we take this as an opportunity to explain the definition and the peculiarities of design abuse. We also offer you advice that allows you to prevent design abuse prophylactically.

The term misuse of design or, as stated in the law, the misuse of legal design possibilities, includes, according to the definition of § 42 AO, all measures that a taxpayer applies on a legal basis to avoid or reduce taxes that contradict the intention of the legislature. In other words, misuse of design constitutes tax evasion or tax reduction by legal means.

Delineation between the application of general and specific abuse rules

Now, of course, one may ask how one should recognize in which cases an intentionally or even unintentionally created loophole leads to such abuse? In the meantime, however, this is already taken into account in many cases when legislating the corresponding legal standards. Because then there are also abuse regulations in this regard, which clearly regulate what the respective law is not intended. § 42 AO, on the other hand, is only responsible for the general cases, i.e. for all those for which no special provision applies. For this reason, we would also like to refer in our article exclusively to these general cases. After all, it is they who raise the question with the taxpayer: “Is this tax arrangement still legal or already misuse of design?”

2nd procedure for clarifying misuse of design

So we look at what leads to the finding of design abuse and how it comes to clarification.

SEGMENT006 2.1. The contribution of the tax consultant to avoid misuse of design

As a rule, the first party to notice an abuse of design is the tax consultant involved. Provided the appropriate competence, he should be able to identify in advance whether a possible abuse has occurred and to remedy it. Particular attention must be paid to this in tax design consulting, for example in tax design models in connection with real estate or holding companies.

2.2. The tax office as a supervisory authority

If this lower court falls away, then usually the tax office is the one who expresses the suspicion that there could be a misuse of design. Of course, this is hardly surprising, because after all, the financial administration strives, even obligated, to prevent unlawful tax losses. However, it is the case in practice that this side often very quickly raises the accusation that there is probably an abuse.

2.3. The out-of-court opposition procedure

Thus, the tax office communicates its view on the existence of misuse of design to the taxpayer by decision. He is now free to counter the accusation by objection. Through the objection procedure, the tax office is given the opportunity to examine both the legal position of the taxpayer and his own on the matter in question. So under favorable circumstances – often also through the help of a tax consultant – a favorable outcome of the objection procedure comes about for the taxpayer. In fact, this is the result of the majority of all opposition reviews.

In the opposite case, however, the taxpayer only has the way through the judicial authorities. For this purpose, the taxpayer submits a complaint to the tax court.

2.4. The judicial procedure to resolve an abuse of design

2.4.1. Decision of the Financial Court

So the taxpayer and the representatives of the tax administration meet again in court. The tax court must now consider whether the disputed facts are in accordance with the provisions of § 42 AO. If the court finds that there is no abuse of design, the tax office can, if justified, appeal to the next instance. The Bundesfinanzhof is also the highest authority in the case law in tax law. Of course, in the opposite case, the taxpayer is also able to address himself to the Bundesfinanzhof.

At this point, however, it should also be noted that the tax courts usually judge in the sense of the taxpayer. Furthermore, the financial authorities often accept such a judgment without resistance. The walk to the Bundesfinanzhof is therefore rather the exception.

2.4.2. The judgment of the Bundesfinanzhof

However, if the Bundesfinanzhof decides on the misuse of design, this is a binding judgment. However, under certain circumstances there may also be a situation that should rather be clarified by other legal bodies. Examples of this would be the Federal Constitutional Court or the European Court of Justice. But let us refrain from this in our considerations. Even the way to the Bundesfinanzhof is, as I said, an exception.

By the way, the statistics in the assessment of misuse of design by the Bundesfinanzhof for the taxpayer looks positive. As we will see in the next section, this is often also due to the argument of the taxpayer, whom the tax authority can only rarely meet effectively.

A clear exclusion criterion for the question of whether there is an abuse of design is that there are reasons that do not imply a tax connection. In other words, one can thus counter the accusation that the arrangement was chosen primarily or even entirely to avoid or reduce the tax. The more clearly it can be seen that the design has no tax connection, the harder it is for the tax administration to maintain the accusation of misuse of design.

An example: A GmbH commits all five participating shareholders as Managing Director. However, this appears to the tax office as an abuse of design, because it recognizes in it too high a deduction by the managing directors salaries. However, this can be countered by proving that each managing director is particularly suitable for a special business and thus has a special responsibility that justifies his position as managing director.

Lack of influence as an exclusion criterion in design abuse

Furthermore, the argument that the taxpayer has no influence on the outcome of the process affected by its design is to be regarded as an exclusion criterion. If it can be justified that the taxpayer cannot influence the whole chain of causes and effects that ultimately lead to the tax avoidance or tax reduction in question, there can be no abuse. Because this precludes the possibility that the design is intentionally intended to avoid the tax.

4.1. The example of chain yawning

A prominent example of this is the so-called chain gifting in the gift tax. Here it is questionable in principle whether the intermediary between the original donor and the person ultimately receiving the gift actually makes the gift, which then leads to a reduced tax. However, the exact circumstances must also be considered. If, for example, the first gifted person still gives away the same sum on the same day – and probably even at the same appointment with the notary – so that there is a reduced tax of the final gifted person, then this is obviously due to previous agreements. This also confirms the suspicion that this constitutes an abuse of design. After all, this behavior suggests that the original gift-giving person orchestrates the whole process of gifts. It will therefore be difficult for her to prove a lack of influence.

4.2. The Federal Finance Court’s ruling on chain-linking

Prominent is the chain giving as an example of the principle of the lack of influence because it was actually assessed by the Federal Finance Court in the sense of the taxpayer. Although in the run-up in particular the tax administration saw in the chain donation an abuse of design and also expected a corresponding judgment, the court spoke out for the view of the taxpayer. After all, it is difficult to prove something to someone that cannot be proven. So you judge here classically with “in dubio pro reo”.